|Global Economic Trends and Social Development (United Nations Research Institute for Social Development , 2000, 64 p.)|
Proponents of liberalization and globalization claim that these help the integration of the world economy - which, in turn, generates fast economic growth (through better allocation of resources and promotion of technical change on account of greater competition, among other factors). Many economists also suggest that free trade and capital movements lead to convergence of real wages and productivity between and within countries (Sachs and Wamer, 1995).
Table 17 summarizes information on the integration of the world economy during the last four decades through trade, flows of foreign direct investment (FDI) and bank loans. An important point that emerges from this table is that the world economy was integrating quite rapidly even before liberalization and globalization. The volume of world exports expanded at a far faster rate during 1964-1973 than during the 1980s and 1990s. Since world real GDP also expanded at a much faster rate during 1964 - 1973 than it has done subsequently, this suggests that the causation may run from growth of production to growth of trade rather than the other way round. Information given in tables 18 and 19 lends further support to this theory. The two tables suggest that tariffs and the non-tariff barriers to trade have been declining in Latin America and East Asia since 1980. In the early 1980s, they were twice as high as in the early 1990s in the two regions; they are likely to have been higher still during the period 1964 - 1973. Notwithstanding these greater restrictions, trade expanded at a much faster rate in that period than it has done subsequently, suggesting that faster growth has led to faster trade rather than the other way round.
Thus it is not the case that during the last two decades the pace of world economic integration has necessarily increased - but it has taken a new form under the regime of freer trade and capital flows represented by liberalization and globalization. The main stylized facts about the new form of world economic integration are:33
· Private capital flows have replaced multilateral and bilateral aid to developing countries as the main vehicle of capital transfer from rich to poor countries. Between 1984-1989 and 1990-1996, net official flows fell by nearly 50 per cent, while net private flows rose by 700 per cent.
· There has been a huge increase in portfolio flows as well as FDI during the last 15 years. Portfolio equity flows were negligible in the 1970s and 1980s, expanded rapidly in the 1990s and comprised about 15 per cent of the total capital flows in 1996.
· FDI and portfolio flows have, however, gone only to a very small number of developing countries. Fourteen countries accounted for 95 per cent of private flows to developing countries.
· Even those countries that have been major recipients of private capital inflows in the recent period have had to contend with the high volatility of these flows. This volatility has invariably proved to be highly disruptive.
33 See Singh and Zammit (forthcoming); Stiglitz, 1994; World Bank, 1999a.
Yet the experience of both developed and developing countries under liberalization and globalization has so far been disappointing. As Felix (1995) and Singh (1997) note, leading industrialized countries have been operating under a regime of more or less free trade, and more or less free movements of capital, since the early 1980s. But, contrary to expectations, the performance of the real economy of the advanced countries during this period has been less than impressive, as is indicated by the following facts:
· GDP growth in the 1980s and 1990s under liberalization is much lower than that achieved in the illiberal and regulated Golden Age of the 1950s and 1960s.
· There has been a comprehensive failure of GDP growth in the later period: 21 out of 22 OECD countries had a lower GDP growth in the second period compared to the first.
· There has been much greater variability of financial variables, such as exchange rates, and real variables, such as GDP and its components, during the 1980s and 1990s.
· Productivity growth during the 1980s and 1990s has been half of what it was in the Golden Age.
· The critical failure, however, is with respect to employment: many European countries have been afflicted by mass unemployment, with unemployment rates in the double digits34
34 See Singh (1997), which considers and rejects alternative hypotheses for the poor performance of industrialized countries during the 1980s and 1990s.
These studies provide useful insights into the consequences of capital account liberalization. At best, however, they provide mixed support for the hypothesis that capital account liberalization has a positive effect on economic growth. (1998b:20)
In principle, free capital movements should smooth out income and consumption over time for individuals and countries, but in practice the experience has been quite the opposite. Financial liberalization, both in developed and developing countries (particularly the latter), has invariably been associated with financial crisis (see Demirgt and Detragiache, 1998; World Bank, 1998b; IMF, 1998a; 1999). Similarly, the Sachs and Warner proposition that economic integration through free trade and capital movements leads to convergence has found little support in more recent work (see, for example, Rodriguez and Rodrik, 1999; Slaughter, 1998; UNCTAD, 1997). Using superior empirical methodology, Slaughters main empirical result is that trade liberalization did not trigger convergence in any of the four cases [that he studied]. If anything, trade seems to have caused income divergence (1998:1).
Why has the liberal economy not delivered? Why is there such divergence between theoretical expectation and empirical reality? This subject has received a great deal of attention from economists in the last decade or so. As Chakravarty and Singh (1988) noted, the case for trade openness is, in principle, very robust. Advantages of openness go much beyond the comparative static benefits of trade emphasized in orthodox analysis. Trade openness may also benefit the economy in one or more of the following ways:
· It may enable a country to concentrate its relatively specialized resources in areas of production where the world demand is highly income- and price-elastic.
· It may lead to diffusion of knowledge, which can bring about considerable upgrading of the quality of local factors of production.
· It may lead to increased competitive pressure, which may eliminate Leibensteins X-inefficiency.35
· Trade may lead to changes in income distribution, which can bring about a greater share of investment in national output.
· Openness may accelerate a Schumpeterian process of creative destruction (in simpler terms, technological progress) and thereby generate faster economic growth.
35 Leibensteins X-inefficiency refers to the inefficiency involved when a firm does not minimize costs of production. This situation may arise when there is inadequate competition to oblige producers to minimize costs.
However, for these benefits to be realized, the role of the government and the question of co-ordination failures are critical. Evidence from the outstanding economic successes of East Asian economies indicates the positive role of the government in institutionalizing learning from the outside world through trade (see Freeman, 1989; Aoki et al., 1997; Singh, 1995a; 1999c). Further, the free trade model assumes that there is always full employment in all participating countries - a very tall order indeed in the real world. John Maynard Keynes was concerned with the possibilities of co-ordination failures at the international level leading to sub-optimal equilibrium of world demand, output and employment. He observed:
... the problem of maintaining equilibrium in the balance of payments between countries has never been solved... the failure to solve the problem has been a major cause of impoverishment and social discontent and even of wars and revolutions... to suppose that there exists some smoothly functioning automatic mechanism of adjustment which preserves equilibrium only if we trust to matters of laissez-faire is a doctrinaire delusion which disregards the lessons of historical experience without having behind it the support of sound theory (Moggridge, 1980:21-22).
During the 1950s and 1960s in industrialized countries, the problem of payments imbalances between countries was resolved at high rates of growth of world demand, output and employment. This has not been the case under financial deregulation and freer movements of capital. Theoretical work on financial flows indicates that the case for free movements of capital is far from being robust. Free trade in financial instruments is fundamentally different from free trade in goods. This is because the former is subject to asymmetric information, agency problems and adverse selection. Some of these problems can occur in trade in goods as well. But they are central to finance. Moreover, in the orthodox model, price formation in the currency or stock markets is based on rational expectations; the model assumes that the prices generated by this process are always fundamentally efficient in Tobins (1984) sense. This view ignores important features of real world financial markets, such as speculation, noise trading and other psychological variables that lead to the observed herd behaviour and contagion, and, through these, to bubbles.
Significantly, the role of variables of mass psychology is fully recognized in historical studies of financial markets and financial crises. Kindleberger (1984), a leading financial historian, suggests that international capital flows have historically been subject to periodic but unpredictable bouts of euphoria and pessimism. Although ignored by adherents of the orthodox model, the importance of these psychological factors is also underlined by market participants and keen observers. In this context, it is useful to reflect on Alan Greenspans analysis of the US stock market crash of 1987 and the Asian financial crisis of the late 1990s. Greenspan observed:
At one point the economic system appears stable, the next it behaves as though a dam has reached a breaking point, and water (read, confidence) evacuates its reservoir. The United States experienced such a sudden change with the decline in stock prices of more than 20 per cent on October 19, 1987. There is no credible scenario that can readily explain so abrupt a change in the fundamentals of long-term valuation on that day. Such market panic does not appear to reflect a simple continuum from the immediately previous period. The abrupt onset of such implosions suggests the possibility that there is a marked dividing line for confidence. When crossed, prices slip into free fall - perhaps overshooting the long term equilibrium - before markets will stabilize.
But why do these events seem to erupt without a readily evident precursor? Certainly, the mote extended the risk-taking, or more generally, the lower the discount factors applied to future outcomes, the more vulnerable are markets to a shock that abruptly triggers a revision in expectations and sets off a vicious cycle of contraction.
Episodes of vicious cycles cannot easily be forecast, as our recent experience with Asia has demonstrated. The causes of such episodes are complex and often subtle. In the case of Asia, we can now say with some confidence that the economies affected by this crisis faced a critical mass of vulnerabilities; ex ante, some were more apparent than others, but the combination was not generally recognized as critical (1998:3-4).
Chang and Singh (1999) combine these perceptions concerning the irrational exuberance and pessimism of the markets with the structural factors present in most developing countries to argue that unregulated capital flows are much too risky for these economies. The latter are subject to frequent internal and external shocks, including large and frequent terms of trade shocks. Moreover, the process of economic development is inevitably uneven, producing winners and losers, which often leads to social strife. With the knife edge quality of the confidence factor, such strife may panic skittish investors in Chicago and New York, not to speak of the rich in developing countries themselves. It is, therefore, not at all surprising to find that capital movements between the rich and the poor countries frequently run contrary to the predictions of the orthodox model. Capital does not always move from the rich countries, where its marginal product is thought to be low (because of capital abundance), to poor countries, where the marginal product should be higher owing to capital scarcity. Thus, we find that in recent years savings have been flowing from developing countries to the United States rather than the other way round. Similarly, prior to the Asian crisis, the major recipients of capital inflows were Asian economies, many of whom did not need these inflows as they already had very high savings and investment ratios (for example, the Republic of Korea and Thailand). On the other hand, the African countries with low savings and investment rates that really do need the capital do not receive it under the current regime of largely unregulated capital flows.